Agriculture is often the largest employer in many lower-income countries. Nevertheless, factors relating to transaction costs for lenders and inherent risk result in the sector receiving less formal credit than the size of the industry would suggest. To illustrate, in Kenya over 30% of the working population works in agriculture, contributing over 22% of total GDP, but the sector receives a mere 3.6% of aggregate formal credit.
Even within the agriculture sector, credit is not allocated uniformly. While smallholder farmers can sometimes meet financing needs using microcredit, and larger agricultural enterprises are more qualified to meet credit requirements of commercial banks, agri-SMEs in particular struggle to access adequate credit in an already credit-constrained sector (see Figure 1).
Figure 1: Distribution of loan frequency for actors in the agricultural sector with different financing needs
Notes: The distribution of credit in the agricultural sector reveals a ‘missing middle’ of agri-SMEs struggling to access credit. Figure generated by author.
Learning from microfinance
The agri-SME financing sector has much to learn from microfinance. Initially, microfinance was celebrated as a silver bullet for poverty alleviation across developing countries. It took 40 years for robust evidence to finally emerge, which revealed a more nuanced reality. Much of the expansion of microfinance was rooted in optimistic belief rather than evidence. Today, the agri-SME financing literature resembles where the microfinance literature was 20 years ago (see Figure 2). Note that the blue line includes all types of literature concerning SMEs, hence representing an upper limit to what is known about agri-SME financing. As the sector grows, it is imperative that the evidence base around the industry grows with it—encouraging learning and ensuring that resources available to lenders are used efficiently while maximising impact.
Figure 2: Growth of academic literature on SMEs and microfinancing
Notes: There is a large discrepancy between what we know about microfinance and agri-SME finance. The blue line represents the stock of the SME literature between 1990 and 2020 and hence is an upper bound to what we know about agri-SME financing. The figure was generated using a database of 34,000 publications we collected from the top journals in economics and development economics.
What do we know?
Up until now, there are two sources of knowledge which help us understand the agri-SME financing space: practitioner findings and the academic literature.
What practitioners tell us
Practitioners report that credit is used to expand operations, integrate farmers into more formal value chains, and improve community welfare. It’s important to note that reports by practitioners are typically not designed for rigorous impact evaluation purposes, and as such most documents rely on qualitative descriptions without making use of counterfactuals. Findings, therefore, are highly relevant for lenders but often lack rigour.
What the academic literature tells us
The academic finance literature is rigorous in its broader impact evaluation approach with respect to agriculture, developing economies, and SMEs but few research studies lie at the intersection of these three fields (see Figure 3). Consequently, existing evidence from the academic literature borrows heavily from related literatures (i.e., microfinance, SME finance in urban contexts) which lack relevance for practitioners (area A and B). We found only one relevant paper at the intersection of all three dimensions (area D). Among other findings, the academic literature suggests that there is evidence for credit constraints faced by risky agri-SMEs and that targeted programmes attempting to improve access to finance can be successful in promoting SME investment and performance.
Figure 3: Distribution of papers included in the academic literature review by type of financial literature
Notes: Most rigorous papers lie at the intersection of SMEs and developing economies while little evidence exists at the intersection of agriculture, developing economies, and SME finance. Figure generated by author.
Marrying rigour and relevance
Going forward, impact evaluation needs to expand the intersection between academic rigour and relevance in the agri-SME financing literature. Only by marrying these two characteristics can findings be used to improve decision-making and allocate resources most effectively (Figure 4).
Figure 4: Current and future overlap between academic rigour and practitioner relevance in the agri-SME financing literature
Notes: There is need for greater overlap between academic rigour and practitioner relevance on the impact of agri-SME financing. Figure generated by author.
CSAF Data Analysis
The IGC has begun to address this evidence gap by partnering with the Council on Smallholder Agricultural Finance (CSAF), a network of 20 social impact investors that collectively lend upwards of US$ 700 million to agricultural SMEs on an annual basis and come together to share learning and develop best practices for agri-SME lending in developing markets. Over 6,700 loans to agri-SMEs were analysed to investigate if firms grow when given access to credit, and how relational lending and experience affects loan terms. The analysis reveals:
- The positive correlation between size of a borrower and length of a borrower-lender relationship is mostly driven by longer relationships being established by larger borrowers.
- As a borrower takes out loans with a lender over a longer period of time, lenders charge slightly lower interest rates and issue larger loan amounts.
- As lenders accumulate experience in a specific market (country and crop), they consequently give out more credit, charge lower interest rates, and experience lower rates of default.
In the CSAF dataset, we only observe firms who receive access to finance but do not observe firms who are unable to secure capital. As a result, we cannot yet make conclusions about whether or not borrowers grow as a result of receiving access to finance. Identifying appropriate counterfactuals (i.e. agri-SMEs who would have liked to borrow, but did not), leveraging expanded data sets, and exploring different research designs will help draw more definitive conclusions around the impact of finance on agri-SME performance.
Key questions for the agri-SME financing sector
The Impact Chain below (Figure 5) identifies points of interaction between different actors in the agri-SME financing space. This figure illustrates how catalytic capital can generate impact flows, through finance and agri-SMEs, towards improved livelihoods and environmental performance. Furthermore, the Impact Chain provides a framework for identifying research questions which are relevant for practitioners. To understand the impact of agri-SME financing, we need to understand each of the interaction points within the chain.
Figure 5: The Impact Chain of interactions in the agri-SME financing space
Notes: The Impact Chain illustrates the interaction points between various actors in the agri-SME financing space that need to be understood better.
This Impact Chain identifies five priority areas of research, exploring the following questions:
- How does catalytic capital impact lender behaviour? Does it incentivise incremental lending to agri-SMEs?
- What is the effect of access to finance on agri-SMEs? Do they experience growth and improved performance?
- What is the relationship between enterprise performance and improvements to farmer livelihoods, food security, inclusion, and environmental performance?
- Does technical assistance increase capacity for SMEs to access and manage finance? Does it improve enterprise performance?
- How does technical assistance compliment increased enterprise performance? Does technical assistance improve farmer productivity and resilience?
Answering these questions would offer a strong first step in deepening our understanding of the agri-SME financing space. However, each of the five research areas consists of numerous sub-questions that require careful examination. For instance, what are the key risks contributing to loan default? Does improved business performance result in agri-SMEs paying higher prices to farmers?
Further research is needed to thoroughly answer the high-level questions set out by the Impact Chain. Currently, IGC is conducting expanded research on how exchange rate, price, and weather shocks affect loan performance. The IGC is also investigating ways of testing credit constraints using new types of data sets and statistical techniques. The evidence gathered will help practitioners, policymakers, donors, and researchers understand the drivers of impact and make informed decisions to create a more resilient and inclusive agri-SME finance sector.